"Treasuries - As A Relative Asset Class - Look Cheap"

Long-duration Treasuries continue to look attractive; a view that I have unwaveringly maintained for the past six months for a variety of diverse reasons. I am still targeting a 2014 low by the end of the summer (3.29% from May 28th), as well as a sub 3.00% 30-year by the end of the year.

However, active traders should be aware of the 2014 pattern where yields rise at the beginning of each month into the Employment Report, but then (mostly) resume falling for the rest of the month. In the days leading up to payrolls, traders who own long-dated Treasuries should temporarily hedge via legging into flatteners.

Of all of the various reasons, private pension demand is the most interesting and compelling. Since it is also the most misunderstood, I plan to devote my note on Friday specifically to the topic (traveling until then). The bottom line is that PBGC rule changes will cause persistent and incremental demand over time that overwhelms net visible secondary market supply. Concerns about funding status will trump the private defined benefit plan manager’s fiduciary desire to ‘maximize return per unit of risk’.

In past notes, I have discussed how Treasury yields look reasonable on a relative basis to the yields on other large sovereigns. However, direct comparisons of nominal yields can be tricky, because real yields may tell a different picture, and currency pressures (or FX manipulations) may also contribute. In this light, I thought it would be prudent - in general terms - to compare the 3.4% yield on the US Treasury 30 year to other assets.

After all, money needs a home. One fund manager recently said to me, “if I sell some of my stocks, what am I going to buy?” The need to stay invested is a powerful tool. However, as investors search for incremental yield, they need to remember to assess if they are adequately being compensated for the risk.

It would be helpful to first remember a few comments made by Yellen during her significant IMF speech last week entitled “Monetary Policy and Financial Stability”. She said, “I am mindful of the potential for low interest rates to heighten the incentives of financial market participants to reach for yield and take on risk...such risk taking can go too far, thereby contributing to fragility in the financial system”. Although she is aware of excesses, she basically said that she will tolerate them and try to contain excesses through macro-prudential tools. The strategy, in short, is ‘pump and regulate’.

I wonder how she defines “excesses” and what she considers financial instability to be.

Various news articles have recently given details about the stellar performance of certain asset classes. Here are a few examples:

Iowa farmland has risen over 15% in each of the past 5 years to consecutive all-time highs. The 32.5% increase in 2010 was the largest annual rise in history.

The total of US financial assets as a percentage of GDP is at an all-time high.

Manhattan commercial capitalization rates (the expected return from rent) have fallen to 4.4%, which is lower than the 2007 real estate bubble. Nationwide office space in business districts nationwide has risen to $300 per square foot on average from $147 in 2010.

Over 50% of all residential real estate transactions in New York City in Q1 were closed without financing and over 35% were from foreign buyers. Prices are 30% higher in the past year. For a foreigner, Manhattan real estate can act as a safety deposit box, an insurance policy, or a hedge against a wobbly home currency.

Since many purchasers are anonymous corporate structures tied to offshore accounts, there might be some ‘dirty money’ aspects. Moreover, new Swiss transparency laws have likely incentivized flows into US real estate fueled further by local taxes on capital.

The Census Bureau estimates that 30% of all apartments from 49th to 70th between Fifth and Park are vacant at least ten months a year. (See New York Magazine article from June 29th)

French cable-television company Numericable recently raised $11 billion in the largest junk deal on record despite the low (non-junk-like) 4.875% interest rate. (See NY Times – Everything Bubble)

The Japanese 10-year yield is below 0.55%. Some European sovereigns yield the lowest in history (France 10’s at 1.65%, Spain at 2.7%), while others are the lowest in hundreds of years. Despite massive monetary and fiscal stimulus, lending facilities, and bailouts, EU growth and inflation are anemic. Valuing EU yields are tricky because of the binary structure. For the moment, it appears that there is a quasi-government guarantee with officials ‘doing whatever it takes’ to maintain the union, thus the convergence of spreads. However, it could unravel quickly should this truth not hold as developments unfold, exposing the potential reckless misallocation of capital of yield-seekers.

These are only a few examples, but the point is that Treasuries as a relative asset class looks attractive.

As I stated in early commentaries, there are other factors.

Expecting a lower longer-run neutral fed funds rate helps valuation. Central clearing and increased bank capital requirements have increased demand for Treasuries and resulted in a shortage of good quality collateral (observed by repo fails). If the PBoC (or BoJ or ECB for that matter) are successful in weakening their currencies, their increased competitiveness with the US would leave them with more dollars which would be recycled into Treasuries. While the front end of Treasuries will be driven by the path of the Fed’s policy rate, the back end will continue to be affected more by geo-politics, international events, and expectations for growth and inflation. Pension demand is the icing on the cake.

Own the long end of Treasuries.

“No problem can be solved from the same level of consciousness that created it”. – Albert Einstein